Market insights and analysis

How dynamic, risk-managed investment solutions are performing in the current market environment

1st Quarter | 2022

Market insights and analysis

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Updates on how dynamic, risk-managed investment solutions are performing in the current market environment.

By Tim Hanna

Major U.S. stock market indexes were down last week. The S&P 500 decreased by 1.87%, the Dow Jones Industrial Average was down 0.29%, the NASDAQ Composite fell 4.53%, and the Russell 2000 small-capitalization index lost 2.92%. The 10-year Treasury bond yield rose 25 basis points to 1.76%, taking Treasury bonds lower for the week. Spot gold closed at $1,796.55, down 1.78%.

Stocks

The new year started off with continued rotation into Value stocks. Growth stocks experienced heavy selling, while long-term interest rates rose significantly.

In Federal Reserve news, the December Federal Open Market Committee minutes showed that members thought it would be appropriate to reduce the size of the Fed’s balance sheet faster than last indicated due to a stronger economic outlook. This contributed to the decline last week.

On the economic data front, nonfarm employment change came in at 199,000, well below expectations of 426,000. The unemployment rate declined to 3.9% compared to estimates of 4.1%. Unemployment claims were at 207,000, slightly above estimates of 199,000. Average hourly earnings month over month rose 0.6%, more than the 0.4% forecast. ISM Manufacturing PMI came in at 58.6 compared to expectations of 60.0. ISM Services PMI was also lower than expected, coming in at 62.0 versus the 67.0 that was forecast.

The divergence in the NASDAQ and S&P 500 continues. Investors have been selling tech and growth stocks and moving money into Financials and Energy. Bespoke Investment Group noted that the overlooked “Finergy” trade has been in motion for some time now. Over the past year, Financials are up 35% and Energy is up almost 55%. Trends that started in 2021 have accelerated into 2022 as investors’ worries increase over a tighter Fed.

Bespoke performed a decile analysis on the Russell 1000 stocks. They separated the Index into 10 groups of 100 stocks and calculated the average year-to-date (YTD) return of the stocks in each decile based on the characteristics shown in the following table.

Only one week into 2022 and the performance divergence has been significant. Deciles with the highest valuations are down 5%–8% on average YTD, while deciles with the lowest valuations are already up 3%–6% YTD. Stocks with no dividends have gotten hit especially hard. It appears the higher the dividend yield, the better the decile performance.

Lately, many of the moves in the Technology and Financials sectors have been impacted by interest rates and fixed income. The Financials sector has trended with the move in the 10-year Treasury yield, while the NASDAQ has trended with the price of the U.S. government long bond.

Shifts in momentum between sectors in the equity markets are a good reminder of how important it is to incorporate active, risk-managed strategies in a portfolio. Whether by seeking to identify outperforming assets or managing downside risk in periods when market volatility is prolonged, active strategies can adapt to changes in market conditions.

Bonds

Trading at three-month lows less than four weeks ago, the yield of the 10-year Treasury ended last week at one-year highs (black horizontal line in the following chart). At one point last week, the 10-year yielded 1.80%, its highest level since the start of the pandemic. Technicians are noting 2% as the next level of resistance and 1.75% as support since the 10-year has broken out to a new value zone.

While yields have climbed since the start of this year, the Federal Reserve minutes have helped propel the 10-year to fresh one-year highs. Discussions of faster and more aggressive rate hikes, as well as reducing the Fed’s balance sheet, put upward pressure on long-term rates.

To put this into perspective, the CME FedWatch Tool increased the probability for a March rate hike from 54% the week before to 75.7% last week. The two-year yield, which tracks fed funds rate expectations, rose 14 basis points to 0.87%. The two-year is quickly closing in on 1%. If the upward trajectory continues, two-year highs are in sight.

T. Rowe Price traders reported, “High yield bonds traded lower due to rates increasing and general risk-off sentiment. Investors also appeared to focus on the reopening of the primary market, which contributed to some weakness in the secondary. Broader risk markets seemed to be assessing the hawkish tone of the Fed’s meeting minutes and the prospect of earlier rate hikes.”

The current interest rate environment and uncertainties on the horizon make having active, risk-managed fixed-income strategies within a portfolio more important than ever. Most investors can remember how important managing equity risk was during the 2008 financial crisis, but the current environment reminds us why it’s also important to manage bond risk.

The past few years have been extremely difficult for fixed-income investors due to historically low yields on bonds (less income for investors) and the sharp increase in rates since 2020 (rates and prices have an inverse relationship). At Flexible Plan Investments, we have many strategies that seek to manage risk in the fixed-income markets, with each being able to take advantage of rising interest rate environments.

Gold

Last week, gold fell 1.78%, continuing to trade near its 50-day and 200-day moving averages. Price action remains at the middle of the one-year trading range. The story hasn’t changed from a technical perspective yet, but some fundamental factors could help push the yellow metal in a positive direction. Potential weakness in the U.S. dollar, worse-than-expected inflation, and geopolitical tensions between military powers could drive up the price of gold.

The Gold Bullion Strategy Fund (QGLDX), designed at its introduction more than nine years ago to track the daily price changes in the precious metal.

The indicators

Our very short-term-oriented QFC S&P Pattern Recognition strategy’s equity exposure was 180% long throughout last week. Our QFC Political Seasonality Index favored stocks last week. (Our QFC Political Seasonality Index is available post-login in our Weekly Performance Report section under the Quantified Fund Credit category.)

Our intermediate-term tactical strategies are positive, although to varying degrees. The key advantages these strategies offer to investors is their ability to adapt to changing market environments, participate during uptrends, and adjust exposure to more defensive posturing during downtrends.

The Volatility Adjusted NASDAQ (VAN) strategy started last week 100% long to the NASDAQ. It changed to 60% long on Wednesday’s close and to 80% long on Thursday’s close. The Systematic Advantage (SA) strategy is 90% exposed to the S&P 500, and our Classic model is in a fully invested position. Our QFC Self-adjusting Trend Following (QSTF) strategy started last week 200% long, changed to 80% long on Wednesday’s close, and changed to 100% long on Thursday’s close. VAN, SA, and QSTF can all employ leverage—hence the investment positions may at times be more than 100%.

Flexible Plan’s Growth and Inflation measure is one of our Market Regime Indicators. It shows that we remain in a Normal economic environment stage (meaning a positive monthly change in the inflation rate and positive monthly GDP reading). Historically, a Normal environment has occurred 60% of the time since 2003 and has been a positive regime state for stocks, bonds, and gold. Gold tends to outpace both stocks and bonds on an annualized return basis in a Normal environment but carries a substantial risk of a downturn in this stage. From a risk-adjusted perspective, Normal is one of the best stages for stocks, with limited downside.

Our S&P volatility regime is registering a High and Falling reading, which favors gold over bonds and then stocks from an annualized return standpoint. The combination has occurred 13% of the time since 2003. It is a stage of higher returns and lower volatility for bonds relative to the other volatility stages.



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